Sonny Malone (Michael Beck) is a frustrated artist and, to make ends meet, paints oversize album covers for record store displays. He briefly meets a mysterious, beautiful girl (Olivia Newton-John) on a Venice Beach boardwalk, who surprises him with a kiss. Later he encounters Danny McGuire (Gene Kelly) playing a soulful clarinet along the beach. Danny shows him his beautiful mansion and reminisces about his days as a big band clarinet player. He confesses that his dream is to open a club and again showcase music. He suggests the two of them go into a partnership.

Sonny continues to run into the girl, who says her name is Kira and suggests that Sonny and Danny renovate an old Art Deco wrestling palace for their music club. Danny sees the building and agrees that it is the ideal venue. Kira suggests that they name the club "Xanadu".

Sonny confesses his love to Kira, but she reveals that she is a "Muse" on a mission to assist the two with their dreams, but must then return to Heaven.

Not much to spoil here. After Kira vanishes, the roller-skating Sonny encounters a wall mural picturing nine dancing Muses, including an image of Kira. He propels himself into the image and finds her in her heavenly surroundings. But the voice of Zeus (Wilfrid Hyde-White) tells him that she must remain there. Zeus finally consents to allowing Kira to make one final visit to Earth, for the opening bash of Xanadu.

The opening night is a huge musical extravaganza, with dancers, roller skaters, jugglers and trapeze artists. Kira performs the disco song of the club's name, then returns to Heaven. Danny orders a drink for the dejected Sonny. When he looks up at the waitress, he sees the image of Kira in an earthly form, and they strike up a conversation

Xanadu is apparently a loose remake of Down to Earth, which, itself, was something of a sequel to Here Comes Mr. Jordan. When Kira reveals to Sonny that she is a Muse, she starts to say "My real name is Terp...", but is interrupted. Terpsichore is one of the nine Muses of Greek mythology, and was Rita Hayworth's role in Down to Earth.